Yet more on the debt-reduction rule (very wonkish–but important)

This post was written by John McHale

Many thanks to Seamus for providing an excellent analysis of the debt rule.   At the risk of overkill, I think it is useful to offer one further angle.  

One aspect of the debt (i.e. 1/20th) rule that may not be fully appreciated it that it is – like the 3 percent deficit rule – a trigger for the Excessive Deficit Procedure (EDP).   In the past, the trigger for the EDP was a deficit greater than 3 percent of GDP.   With the revised Stability and Growth Pact, the EDP can be triggered either by an excessive deficit or an insufficient rate of reduction in the debt to GDP ratio.   This fact is important for reasons that link to the discussion about the uncertainty surrounding growth prospects across recent threads.  

To see this, it is useful to recast both the deficit and debt-reduction rules in a way that makes them more easily comparable.   (I will make some approximations to make the maths a bit more digestible, but they don’t change the basic message.)

The equation for the change in the debt to GDP ratio can be approximated by,

Δd = (i – g)d-1 - ps,

where d is the debt to GDP ratio (in percent of GDP), i is the average nominal interest rate on outstanding debt, g is the nominal growth rate, d-1 is last year’s debt to GDP ratio (in percent of GDP), ps is the primary surplus (in percent of GDP), and Δ represents the change in a variable (measured in percentage points of GDP). 

Noting that the overall deficit as a percent of GDP (denoted def) can be written as id-1 – ps, we can rewrite the equation as

Δd = def – gd-1.

The 3 percent deficit rule says that the deficit must be below 3 percent of GDP.   Using the last equation, we can rewrite the deficit rule as a debt reduction rule,

Δd < 3 – gd-1.

Ignoring the averaging procedure that Seamus details in his post below to keep things simple, we can write the debt reduction rule as,

Δd < (1/20)(60 – d-1) = 3 – 0.05d-1.

Both rules take a surprisingly similar form.   Given the existence of deficit rule, the debt-reduction rule only binds on fiscal policy (in the sense of triggering an EDP) if the nominal growth rate is less the 5 percent per year.   (Note this is consistent with Seamus’s calculations given that the deficit is projected to fall below 3 pecent of GDP in 2015.)

(As an aside, some commentators have noted the superiority of debt-reduction rules over deficit rules.   I agree with this as a general principle.   But it is not necessarily the case when it comes to comparing the particular rules we have above.  The deficit rule has the advantage of being “growth contingent”: the implied required rate of debt reduction falls as the growth rate falls.   The debt-reduction rule is insensitive to the rate of economic growth.   I see the growth contingency as an attractive feature of the deficit rule.) 

While noting yet again that the debt rule is already in place under the revised SGP and so not new to the fiscal compact, critics of the rule have a point when they draw attention to possible drastic implications of the rule in a very low-growth scenario.  (In our previous posts, both Seamus and I took existing projections from the IMF and Government (SPU).  These projections are based on a return to reasonable growth rates.   But there is downside risk to these relatively benign growth scenarios.) 

This is where the fact that the debt-reduction rule is a trigger for the EDP becomes so important.   If the rule actually forced debt reductions according to the third equation above, the results could be catastrophic.    To take an extreme case, if nominal growth was zero percent and the debt to GDP ratio was 120 percent, then the rule would require that the debt to GDP ratio is lowered at the rate of 3 percentage points per year.  

This would be crazy in the context of zero growth; it would require a overall surplus of 3 percent of GDP and a primary surplus of about 9 percent of GDP.   But it is not what would happen.   If the rule is not met the country would enter the EDP.   Under the EDP, a deficit reduction path would be worked out that would balance the need to move towards compliance with the need to phase the adjustment over time.    The fact that what the debt-reduction rule does is trigger the EDP is a critical fact in understanding the implications of the rules.

Note: The post has been corrected for an error in the original version. 

24 Responses to “Yet more on the debt-reduction rule (very wonkish–but important)”

  1. The Dork of Cork Says:

    I am really beginning to think yee guys truely believe that shaping a physical economy rigidly around a hypothetical variable construct is somehow a good thing.
    (Its the old falling for ones own Bullshit warning sign)
    What has become of the economics profession ?
    Its illustrates how far we have descended into the pit I suppose.

    The modern technocratic state is a strange beast for sure but its the nature of its focus which is truely puzzling.
    I don’t think Goverments have ever been run in such as fashion before - with perhaps the very sick Austrian Hungarian empire a exception.

    One must ask what is the true purpose of this debt management agency pretending to govern along altruistic lines.

  2. The Dork of Cork Says:

    These EDP control mechanisms are a function of a lack of final payment mechanisms withen the European & global monetary system.
    This is used as a method of money control by the financial elite operating behind the curtain.

    Compliance ?
    Compliance to whom ?
    I have no time for this needless complexity
    Its the duty , I repeat THE DUTY of exchequers to produce tokens when not enough medium of exchange is available to grease the wheels of commerce.
    Its got nothing to do with debt.
    This deliberate mixing of debt and money is a monstrosity that should be challenged repeatedly.

    For the first time Finance is trying to gain control of the printing press itself - everything about thus European Frankenstein experiment should be rejected.
    Its the most Orwellian project ever conceived.

  3. Colm Brazel Says:

    I agree with lots of John’s analysis, plus this document provides other exceptional adjustment scenarios that can be invoked:

    http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:306:0033:0040:EN:PDF

    The reality is growth rates are being revised downward as the real effects of our debt burden and austerity begin to kick in. Draghi’s austerity will not lead to growth.

    The biggest problem is the burden of bank debt contributing as much as 40% of our debt/gdp ratio. Growth in the economy will not pay for this. Our growth rates under our weight of debt are being driven downward and we are in negative GNP already.

    Unfortunately LB/FG have failed to address their failure to achieve significant reductions on our odious debt levels and will use facetious figures like the above re debt sustainability to once again try to prove the Irish economic Titanic is not heading for Davy Jones’s locker and con the Irish electorate they should sign up for an even more miserable set of austerity rules.

    I’ve previously made the point,

    Our negotiating team should stick with the purpose of negotiating down our obligations under the present bailout either by way of a new EFSF bond that should include writing down and burden sharing of the odious IBRC ELA/PN programme or burden sharing by other means. The notion that we would find the debt sustainability levels of our present bailout unsustainable and seek to get another bailout under ESM to pay for the present EFSF bailout is farcical.

    However I’ve a couple of questions re the ‘Compact’ on how it fits in with our current bailout.

    1. Surely the terms of our current bailout provide a get out clause from the terms being demanded under the Compact?

    2. The compact cannot retrospectively impose conditions on our original bailout?

    3. The ” the 3 percent deficit rule – a trigger for the Excessive Deficit Procedure (EDP) ” only come into being when our present programme is finished.

    4. The present EFSF programme will continue until the money is paid back?

    Its difficult to believe those already in bailout programmes are being asked to sign up to more difficult programmes than ones they currently belong to ?

    5. What exactly is the relationship between our current bailout under EFSF and any further bailout under ESM?

  4. Colm Brazel Says:

    Re ” If the rule actually forced debt reductions according to the third equation above, the results could be catastrophic. ”

    The catastrophe will only be triggered by failure to write down debt and burden share.

    This is the only real solution to disastrous austerity economics currently wreaking the economy.

  5. The Dork of Cork Says:

    Billy blog

    bilbo.economicoutlook.net/blog/?p=19276

  6. Colm Brazel Says:

    @ Dork of Cork

    tks for link, His piece beginning ‘Ireland – as a reality’ certainly very interesting and well worth reading, some of the measures he advocates for EMU prior to that, a bit hallucinatory :-)

  7. The Dork of Cork Says:

    @Colm
    Again , I don’t agree with all of what Bill states given the open nature of the Irish economy.
    But he does come from Australia which as Brian Lenihan might have said is a very big Island.

    But his macro understanding of the flaws of the euro economy / banking system in a free floating currency world is very accurate in my opinion.

  8. Colm Brazel Says:

    RE ” The deficit rule has the advantage of being “growth contingent”: the implied required rate of debt reduction falls as the growth rate falls. ”

    What is required is stimulus not some cure worse than the disease that will kill the patient. If the deficit rule were further refined while remaining “growth contingent”; but the required deficit reduction could not be factored away due to low growth or no growth; then, rather than the debt reduction for that year not being applied, if debt repayments were ‘written off entirely’ for that year to allow for the required deficit reduction to be achieved, this would be more beneficial than postponing repayments.

    Markets would be able to see an end in sight. Rules could still kick only where growth could handle deficit reductions.

    Unpayable debt would be treated for what it actually is and could be absorbed over time through ESM.

    Note ‘written off entirely’ means again even if the programme member cannot achieve its deficit reduction for that year due to the low growth and the weight of loan repayments it must endure, that loan payments for that year be written off and regarded as paid in full.

    Debt write down is the name of the game. For political and economic reasons we are talking about the breakup of the euro otherwise.

  9. The Dork of Cork Says:

    @Colm
    No shortage of money for our Northern Brethren….

    “Portadown Station on the Belfast to Dundalk and Dublin main line is to receive a £3.6m refurbishment.
    Works will include a new atrium at the Obin Street entrance and lift access and a new footbridge to connect to the island platform.
    An external facelift will also take place and new public and staff facilities will be provided. Work is scheduled for completion in December 2013.

    Portadown is the fifth busiest station on NIR with around 900,000 passengers annually.”
    http://www.railstaff.co.uk

    Although personnely I don’t think cosmetic improvements are a priority up there -
    The money would have been better spent getting a start on the old Portadown to Armagh section of the line.
    en.wikipedia.org/wiki/Armagh_railway_station

    For 3.6 million they could have got the already functional Lisburn / Antrim railway up and running using the old reliable 450s that they are now scrapping mindlessly……. oh the waste the waste of it all.
    http://www.youtube.com/watch?v=x9YK8C5RUBo

  10. The Dork of Cork Says:

    More positive news from Railstaff magazine.
    Lets all thank Virgina for doing something constructive.

    Ireland’s first community rail partnership has recorded a notable success.

    Last month Iarnród Éireann started running a new through Intercity service from Limerick to Dublin via the Nenagh / Ballybrophy branch.

    This is the first time for around 30 years that a regular through service to Dublin has operated.
    The service departs from Limerick (Colbert) station at 05:15 picking up at Castleconnell, Birdhill, Nenagh, Cloughjordan, Roscrea and Ballybrophy, where it reverses to continue on to Dublin Heuston station, arriving at 08:25. There are also 06:25, 16:05 and 17:05 branch services from Limerick all with connections to Dublin from Ballybrophy.
    A change is required for passengers returning in the evening as trains are unable to access the branch platform from the down main line at Ballybrophy.
    Mixed fortunes
    The Limerick to Ballybrophy branch line has had mixed fortunes in recent years.
    At a time when the new motorway to Limerick was opened, services were reduced to 25mph on long stretches of the branch due to temporary speed restrictions, many of which remained in place despite tracks being renewed.
    The demise of the Limerick cement factory also lead to the end of the regular freight trains on the line carrying shale. More recently the line had been mooted for possible closure.
    A knight in shining armour appeared though in the form of Councillor Virginia O’Dowd from Nenagh. She promoted the services on the railway and managed to get Iarnród Éireann to introduce a morning commuter train into Limerick from Nenagh.
    She also managed to establish the first Community Rail Partnership in Ireland for the branch line which without a doubt has contributed to the recent upturn of events and the new through service.”

  11. Colm Brazel Says:

    @ Dorc

    tks for interesting posts on transportation. Leaving the euro, rejoining sterling and a new Commonwealth Scot/Wales/England/32 County with debt writedown would be a better option for us and I’m no republican. The euro mess doesn’t work and there’s no plans to make it work, only plans to get the money back.

    I’ve an interest in pure Maths but havn’t done the branch used in economics. Anyone got a link to a good reference book to some of the standardized equations used.

    OT just heard Richard Bruton appealing for stability a Y vote would give. Seems Y is the most unstable, perilous and dangerous canary in the goldmine edict an economy in the state Ireland is in, that it could go for….

    No debt writedown whatsoever, all debt to be repaid plus a deficit procedure austerity no growth gun to the head with a blackmail clause….

  12. The Dork of Cork Says:

    @Colm
    I don’t think a Sterling link is all sweetness and light being something akin to the third or fourth circle of hell or perhaps the 8th circle.
    But the Euro is most definitely the 9th circle in my opinion.

  13. Paul W Says:

    The problem I have with the hardwired FC formulas is the inability of any such formula to deal with unforseen shocks /consequences. For example: In the real world, I have in the past been involved with very sophisticated mathematical models e.g. based on 30 years of US Prime vs Libor differential, showing at least 1:1+ million chance that this differential would not compress below a certain historical mean % - only to be followed a year later by the implosion of that differential. Or actuarially verified models simulating and monetising future life annuity cashflows based on mass US mortality statistics, all stressed and sensitised, where the credit crisis itself blew away the economics of the models concerned. Many, many more examples. Another example - based on previous average statistics, we have a CBI recently indicating that the reduction in Ireland of property values has already overshot by up to 26%….Complete nonsense. As as finance person and economist knows, there is simply no perfect “hedge”. In 20+ years in international finance, I have never seen any such model work particularly well over time in any wider financial sphere than highly limited and controlled circumstances.

    Obsession with models, to the point where they are seen /treated and rigidly implemented (in this case on an institutionalised basis) as ends in themselves, is dangerous and blinding in real life circumstances. These models are mere hypothetical predictive tools, and that’s all. I “predict” that the inability of the FC formulae to deal with as yet unknown or unintended consequences will very quickly become obvious. Then, the inability to adjust and evolve the rules quickly, in near-to-real timing, will be the FC’s downfall (assuming it is implemented).

  14. Paul W Says:

    …and in the meantime, valuable time for rectifying Ireland’s debt situation will be lost and Ireland’s economy will deteriorate (until the pain point becomes too much).

  15. David O'Donnell Says:

    @Colm Brazel & The Dork from Cork

    Would you two like a room - all to yourself. You might even score - whatever about one over a score! 5* available now at cut rate prices throughout Hibernia due to all this austerity and the imperatives of NAMA cash flows. Personal WiFi included - breakfast optional.

    Enjoy!

  16. DOCM Says:

    @ All

    FYI

    http://online.wsj.com/article/SB10001424052702304746604577383991138106510.html?mod=googlenews_wsj

  17. DOCM Says:

    @ Paul W

    I agree!

    P.S. I wonder if the other contributors to this thread so far might not consider taking a train together to Cork.

  18. DOCM Says:

    @ All

    In case anyone missed it, this excellent and factual commentary by Arthur Beezly of the IT on the likely impact of a no vote.

    http://www.irishtimes.com/newspaper/world/2012/0503/1224315513538.html

  19. David O'Donnell Says:

    @DOCM

    Love your logic - a commentary on the ‘future’ being ‘factual’. You could make a fortune with it …

    Hey - I rate Arthur meself .. but there are limits to partiality, even around here.

  20. Paul W Says:

    @ DOCM That’s a thought……Good Friday 2013 though….I need to book a flight well in advance; I’v noticed that the fares to Ireland have gone up approx. threefold in the last two years… I certainly need to buy MH a drink……he needs a day off, and the women think he’s goodlooking when he smiles (that rare event when its a case of the way he “looks at them”)!!

  21. The Dork of Cork Says:

    @DOCM
    Your assumption is that coin of the state should be provided by private markets.
    What is a state if it has no money tokens ?

    And yes I like trains as I don’t want to give all me money to whoring Arab shieks & slave arbritrage Bankers.

  22. David O'Donnell Says:

    @JmCH apologies for off-thread but DOCM does trigger me default option at times …

    @DOCM
    Counterpoint to WSJ [p.s. pls add subheadings to your FYIs; Ta]

    FYI Berlin Calling

    It could be an uncomfortable weekend for German Chancellor Angela Merkel, with three crunch votes taking place on Sunday. Elections in Greece and France could torpedo her strategy to solve the euro crisis if voters reject pro-austerity candidates, while a state election in Germany may weaken her conservatives domestically.

    Angela Merkel’s position as German chancellor is becoming increasingly contradictory. At the federal level, she reigns unchallenged, while her opponents falter. But at the level of Germany’s individual states, her power is crumbling and her center-right Christian Democratic Union (CDU) is bracing itself for further setbacks. At the European level, meanwhile, she has become a figure of hate for many, as her pet project, the fiscal pact, is increasingly called into question.

    http://www.spiegel.de/international/europe/three-key-elections-pose-dangers-for-merkel-a-831356.html

  23. Paul Hunt Says:

    Jeez, lads. It looks like ye’re verging on losing the plot - and confirming the demographic analytics highlighted by Prof. Lane in his most recent post. I view this post by John McHale - following on from the previous post by Seamus Coffey - as confirming that Ireland, for its own sake, needs to push on harder than anything that might be imposed by the Fiscal Compact. The other point that often seems to be missed is that these perceived-to-be ‘hard and fast’ rules will be enshrined in law - not in the Constitution. As law they will provide a measure of ‘hard constraint’, but is is merely establishing this where none really existed under the previous S&GP. Rational politicians and policy-makers in every polity will want to operate well inside this ‘hard constraint’.

    It is only those who want to push up against this ‘hard constraint’ - and who want to have the discretion to breach it unilaterally (’dancing at the edge of the fiscal cliff’) - who are opposed to this. And, as John McHale, has pointed out, even if enshrined in law, there will be mechanisms and procedures in place to ensure sensible implementation. In addition, there will always be flexibility in the implementation. The simple objective is to proscribe self- and other-damaging flexibility at the member-state level.

    Unfortunately under the previous 2 and a half party system, each faction, to varying extents, used the state’s resources and apparatus often excessively to implement policy and to secure political support. FF generally operated under little restraint - which is why we are where we are. FG generally tried to restrain Labour, but it often attempted to out-FF FF. And when restraint was required (cf ‘82-’87) Labour trumped FG. Voters have come to accept this in the last 50 years. The breakdown of the 2 and a half party system has resulted in a re-configuration of the ‘raid, tax and spend’ brigade - largely to the left of Labour and leaching much of its support. FG, alone, is compelled to try and hold the line. FF will always behave opportunistically in opposition. And Labour governing politcians are trapped between a rock and hard place - recognising their governing responsibility and watching their support leach away rapidly.

    This is the brutal politcial economy. The ‘raid, tax and spend’ brigade have seized the perceived moral high ground - suitably reinforced by an unswerving atavistic belief in the Mythic and Transcendent Republic. We see plenty of it here. Those who seek to advance the rational, strategic arguments tie thenselves up in tchnical knots that secure no traction with the public or are easily portrayed as “Paudeen fumbling in the greasy till”. The governing politicians resort as is their wont - and true to their form prior to Lisbon I - to brow-beating, bluster and scare-mongering.

    It is true that something will have to give in Europe, but the primary obligation is on Ireland’s governing politicians and regulators. Another bit of sense has emerged, again of all places, from The Economist:
    http://www.economist.com/node/21554197

    The following extract highlights the challenge and the dilemma for governing politicians and policy-makers in the creditor nations (and in Brussels):

    “The Goldilocks policy, as the IMF calls it, urges countries to embark on a gradual fiscal adjustment in the short term, if the markets allow it, coupled with a credible medium-term debt-reduction plan. European officials are now debating whether they can make fiscal targets more flexible without losing credibility, and without giving governments a licence to break the rules. Germany argues, with some justice, that the southern Europeans will reform only under extreme duress. It did not happen in good times, so now it must in bad times, declares one Eurocrat.”

    The structural reform agenda cannot be postponed any longer in Ireland. Governing politicians will have to level with the voters - and hold FF’s feet to the fire. Brow-beating, bluster and scare-mongering will repel enough voters to hand victory to the ‘raid, tax and spend’ brigade. The self-serving rank hypocrisy, disingenuousness and obstructionism of this brigade must be exposed, confronted and defeated via the democratic process.

  24. Ciaran j Says:

    Paul hunt while as usual you make some good points and nobodies going to disagree about the need for a good clear out and restructuring of Irish public life , you dont really seem to be engaging with the fact that these budgetary rules would have done nothing to stop the current crisis, as demonstrated by the fact that neither the comission not the IMF forecast the present budgetary problems of Spain or irelAnd. Plus surely if we’ve learnt anything in the past whole it’s that balancing a budget in the midst of a recession , without recourse to a devaluation , is easier said than done. Over the past few years we’ve had pretty big cutbacks(not enough in your opinion I know) without seeing any proportionate fall on the deficit. We need more that budgetary rules! You seem a lot of the time to be suggesting that if we’re the star pupils as regards reform, austerity etc then our European masters will take pity on us. Personally I struggle to see it. After all for propaganda purposes we already seem to have been designated the role of teachers pet and a lot of good it’s done us

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